Low oil prices, declining sales tax revenues, and unfunded pension obligations are some of the reasons cited for Moody’s Investors Service decision to downgrade the City of Houston’s bond rating.

In a report issued on March 16, the city’s rating was dropped to an Aa3 from Aa2, affecting approximately $3 billion in previously issued bonds. The move means that it will likely cost the city more money to repay its debt.

“The downgrade to Aa3 reflects weakening economic and financial performance driven by prolonged decreases in oil prices,” officials at Moody’s wrote in a report. “It also reflects the city’s high fixed costs, large unfunded pension liabilities (among the highest in the nation), as well as property tax caps.”

“Since entering office in January of this year, I have devoted my full attention to addressing an anticipated budget shortfall and many of the concerns that Moody listed,” Turner wrote in a statement. “Based on the points referenced above, in addition to the actions I am taking to engage all stakeholders in shared sacrifice, I am extremely optimistic that the City’s credit rating will stabilize in the next report.”

Moody’s statement on the report, along with Turner’s full statement, can be read below.

Moody’s Investors Service has downgraded the City of Houston’s (TX) general obligation limited tax rating to Aa3 from Aa2, affecting approximately $3 billion in previously issued bonds. Concurrently, Moody’s assigns a Aa3 to the City of Houston, TX’s $600 million Public Improvement Refunding Bonds, Series 2016A. The outlook remains negative.

The downgrade to Aa3 reflects weakening economic and financial performance driven by prolonged decreases in oil prices. It also reflects the city’s high fixed costs, large unfunded pension liabilities (among the highest in the nation), as well as property tax caps.

The Aa3 also considers recent positive General Fund performance, and growth in non-energy sectors that has offset some of the softening. Additionally, the rating recognizes the positive actions taken by the new Mayor and his plan to engage several stakeholders to modify the city’s fixed costs and generate additional revenues, all within the next 18 to 24 months. These plans signal a change from past initiatives, and positive movement on the plans will be key to stabilizing the credit profile.

Rating Outlook

The negative outlook reflects the recent weakness in economic and sales tax performance, fueled by energy companies’ reduced investments in personnel and capital, as oil prices have remained low. The recent weakening in sales taxes is also contributing to the expected budget gap at fiscal year end 2016, with the city expecting to draw on an already somewhat limited reserve position, compared to peers.

The negative outlook additionally reflects the challenges the city faces from growing pensions costs and liabilities, which are compounded by significantly limited revenue raising flexibility. Fixed costs remain a high portion of the budget (a little over 31% in FY 2015). Costs have grown significantly over the past five years, and are expected to grow absent any pension reform. Management, under the new Mayor, has identified initiatives to address the structural imbalance and stem the increase in long-term liabilities. Positive momentum and implementation of the plans will be key credit considerations going forward.

Factors that Could Lead to an Upgrade

Stabilized economy with a return to strong growth; improvement in employment performance and other economic indicators

A sustainable plan to manage pension liabilities that do not threaten city’s fiscal health; structurally balanced operations with full pension contribution

Removal of revenue cap, providing city with flexibility to capture growth in assessed values

Strong operating performance with a trend of surpluses to boost the reserve position, and increase liquidity

Factors that Could Lead to a Downgrade

Further economic deterioration beyond current projections

Failure to address projected deficits either through revenue flexibility, reduced spending or a combination thereof, leading to a reduction in reserves

Lack of sustainable plan to address growing pension liability

Legal Security

The bonds are secured by a direct and continuing annual ad valorem tax, levied against all taxable property within the limits prescribed by law.

Use of Proceeds

Proceeds of the sale will refund about $100 million of existing commercial paper debt, while the remainder will refund certain maturities of the city’s outstanding debt for an expected net present value savings of 8.5%.

Obligor Profile

The City of Houston is the largest city in the state, and fourth largest city by population in the U.S.. Located in Harris County, the city has home to an estimated 2.2 million people. Some of its main economic drivers include energy and resources, manufacturing, and logistics.

Methodology

The principal methodology used in this rating was US Local Government General Obligation Debt published in January 2014. Please see the Ratings Methodologies page on www.moodys.com for a copy of this methodology.